(Bloomberg) -- The secret to generating outsized gains in emerging-market stocks is to focus on companies with steady cash flow and pricing power, according to a group of fund managers who outperformed a broader market that barely budged this year.
The MSCI Emerging Markets index is up just 1.2% in 2023, still underperforming US benchmarks by a large margin after two years of declines. But within the broader market there have been plenty of winners: around 682 emerging market stocks are up this year, compared with 492 last year, giving stock pickers this year a better chance to select winners.
Kumar Pandit, whose Emerging Markets Dividend Growth Fund at Somerset Capital Management has returned 11% this year, says the key to that outperformance against an inflationary backdrop has been focusing on companies with pricing power.
“If you are the best at what you do, then you’ll be able to pass through your cost inflation onto your customers,” Pandit said. “Your competitors won’t be able to do that in a downturn, so you take more market share and emerge stronger than your peers.”
With the cost of capital surging globally, Pandit said he’s also looking for companies that can finance growth through their own cash flow, rather than relying on credit or equity markets. Among his top picks are Taiwan Semiconductor Manufacturing Co., which has risen about 28% this year in dollar terms; SK Hynix Inc., a rival of Samsung Electronics, which is up 73%, and Kaspi.kz JSC., a payment processor based in Kazakhstan, up about 31%.
Investing in emerging markets means navigating a number of obstacles, from currency risks to geopolitics. Elevated interest rates around the world are tamping down on demand and investment. And after the war in Ukraine and resulting sanctions against Russia burned many emerging-market funds last year, the Israel-Hamas war that started last month made it clear that geopolitics remains a top risk.
Worries persist that the latest war could still spiral into a broader Middle East conflict, dragging in major powers and possibly causing an oil-price shock. Meanwhile the Chinese economy is still struggling, spurring a major emerging-market stocks index to lag US equities by the most in 36 years.
“Over the past two years, geopolitics has played a larger role than it has previously in emerging markets, so that’s an additional layer of risk, which we actually factor into our considerations,” said Chetan Sehgal, lead portfolio manager of Templeton Emerging Markets Investment Trust, a unit of Franklin Templeton.
Buying companies with strong earnings power, such as his largest holding, Taiwan’s TSMC, provides an advantage in navigating the turmoil, said Sehgal, whose fund has gained 9.4% this year.
Exposure to energy can also offer some protection against geopolitical turmoil and rising inflation, said Fredrik Bjelland, head of private Skagen AS’s emerging-market equity fund in Stavanger, Norway. He’s betting on top holding China National Offshore Oil Corp., China’s main deepwater explorer, which is up about 29%.
“We believe that energy holdings provide a natural hedge,” Bjelland said.
Glen Finegan, lead portfolio manager and a co-managing partner at Skerryvore Asset Management, said his biggest holding is Femsa, a Mexican bottler of Coca-Cola and a convenience-store operator. It has a strong history of being well managed and generating good growth among its franchises, and has gained 43% this year.
“You really need to look at businesses with pricing power, with models that help protect you from inflation,” Finegan said. His fund has gained 7.2% this year.
--With assistance from Srinivasan Sivabalan.
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